Chapter 1:

Accounting for Financial Liabilities

Objectives
1.
2.

3.
4. 5.

To describe long-term liabilities and describe how they are valued To identify the nature and types of long-term liabilities-bond To explain the methods of bond discount and premium amortization To prepare the related journal entries To describe the accounting treatment other long term liabilities

Long-Term Debt

Consists of present obligations not payable within the operating cycle of the business, or a year whichever is longer. Long-term creditors have no vote in management affairs and only receive a stated rate of interest regardless of the level of earnings. Covenants or restrictions, for the protection of both lenders and borrowers, are stated in the bond indenture or note agreement.

Bonds Payable

Arises from a contract known as a bond indenture. Represents a promise to pay the principle at maturity and periodic interest based on the stated interest rate and the face value of the bond the different types of bonds such as term bonds, serial bonds, secured and unsecured bonds, convertible bonds, commodity-backed bonds, deep discount bonds, registered, and coupon bonds.

Exercise 5.1: Issuance of Bonds

Ghostbusters Corporation issues RM300,000 of 9% bonds, due in 10 years, with interest payable semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds.

Solution for Exercise 5.1

n = 10 x 2

i = 10%/2

PV of the principal: 300,000 x 0.37689 PVOA of interest payable: [(9% x 300,000)/2] x 12.46221 Price of bond

113,067
168,240 281,307

Valuation of Bonds Payable

The price of a bond is determined by the interaction between the bond's stated interest rate and its market rate. a) A bond's price is equal to the sum of the present value of the principle and the present value of the periodic interest. b) If the stated rate = the market rate, the bond will sell at par. c) If the stated rate < the market rate, the bond will sell at a discount. d) If the stated rate > the market rate, the bond will sell at a premium.

Accounting for the Issuance of Bonds

1.
2.

The face value of the bond is always reflected in the bond payable account. When a bond sells at a discount, the difference between the sales price and the face value is debited to Discount on Bonds Payable.

This is a contra-account to Bonds Payable.

Accounting for the Issuance of Bonds (cont.)

3.

When a bond sells at a premium, the difference between the sales price and the face value is credited to Premium on Bonds Payable.

This is an adjunct account to Bonds Payable.

4.

Bonds sold between interest dates.

The price includes the interest accrued since the last interest payment. ii. The accrued interest is credited to Bond Interest Expense.
i.

Exercise 5.2: Bonds Payable

The Goofy Company issued RM200,000 of 8% bonds on 1 Jan 2000. The bonds are due on 1 Jan 2005, with interest payable each 1 July and 1 Jan. Compute the issue price at a) 100 b) 97 c) 105 Prepare journal entries for both investee and investor

Solution for Exercise 5.2

at 100
Investee: (000) Dt Cash 200 Kt Bonds Payable 200 Investor: Dt Investment Kt Cash

at 97
Investee: (000) Dt Cash 194 Dt Disc. bonds 6 Kt Bonds Payable 200 Investor: Dt Investment Kt Cash 194 194

at 105
Investee: (000) Dt Cash 210 Kt Bonds Payable 200 Kt Premium Bonds 10 Investor: Dt Investment Kt Cash 210 210

200 200

Amortization of bond discounts and premiums

Two methods: 1. Effective interest method is the preferred procedure used to calculate periodic interest expense. The carrying amount of the bonds at the start of the period is multiplied by the effective interest rate to determine the interest expense. 2. Straight-line method may be used if the results are not materially different from those produced by the effective interest method.

Effective interest method

Carrying Value of Bonds = Face Value Plus Premium (or Less Discount). Interest Payable = Stated Interest Rate <> Face Value of Bonds. Interest Expense = Effective Interest Rate <> Carrying Value of Bonds.
If a premium exists: Dr Interest Expense Dr Premium on Bonds Payable Cr Interest Payable If a discount exists: Dr Interest Expense Cr Discount on Bonds Payable Cr Interest Payable XX XX XX XX XX XX

Exercise 5.3:
Amortization of Bonds Payable
Donald Duck Company issued RM600,000 of 10%, 20-year bonds on 1 Jan 2002, at 102. Interest is payable semiannually on 1 July and 1 Jan. Donald Duck Company uses straight-line method of amortization for bond premium/discount. Prepare the journal entries to record:
a)The

issuance of the bonds b)The payment of interest on 1 July c)The accrual of interest on 31 Dec

Solution for Exercise 5.3

a)

Issuance of bonds
Dr Cash (600,000 x 1.02) Cr Bonds Payable Cr Premium on bond Payment of interest on July 1 Dr Interest expense Dr Premium on bond p/able Cr Cash 612,000 600,000 12,000 29,700 300 30,000

b)

Solution for Exercise 5.3 (cont.)

c)

Accrual interest on 31 Dec Dr Interest expense Dr Premium on bond p/able Cr. Account payable
1 Jan 2003 Dr Cr.

29,700 300 30,000

Exercise 5.4:
Amortization of Bonds Payable
Mickey Mouse Company issued RM600,000 of 10%, 10-year bonds on 1 Jan 2002. Interest is payable semiannually on 1 July and 1 Jan. Mickey Mouse Company uses effective interest method of amortization for bond premium/discount. Assume an effective rate yield of 11.5% Prepare the journal entries to record:
a)The

issuance of the bonds b)The payment of interest on 1 July c)The accrual of interest on 31 Dec

Solution for Exercise 5.4

a) Mickey Mouse (Issuance of bonds) i=11.5/2, n=10x2
PV 600,000 x 0.10685 PVOA 30,000 x 15.5330 Price on 1 Jan = 64,110 = 465,990 = 530,100

Dr Cash Dr Discount on bond Cr Bonds payable

530,100 69,900 600,000

Solution for Exercise 5.4 (cont.)

Cash Interest exp.
30,481* 30,508 30538

Amort. Disc
481** 508 538

1 2 3

30,000 30,000 30,000

Balance of Bonds 530,100 530,581*** 531,089 531,627

* 11.5% x 530,100 x 6/12 = 30,481

** 30,481 30,000 = 481 *** 530,100 + 481 = 530,581

Solution for Exercise 5.4 (cont.)

b)

b)

Interest expense on 1 July Dr Interest expense Cr discount on bond Cr. Cash Interest expense on 1 Jan Dr Interest expense Cr discount on bond Cr. Interest payable

30,481 481 30,000 30,508 508 30,000

Cost of Bonds Issue

The issue of bonds involve numerous costs:

Legal and accounting expense, administrative expense (printing doc/prospectus), underwriting fees.

These costs do NOT represent an asset Methods of recognition:

1. 2.

As an expense charge to income statement immediately As a liability debited to a deferred charge account

Exercise 5.5: Cost of Bond Issue

Assume that Cyber Bhd issued a RM40,000,000 five-year bond at its par value on 1 January 1999. The bond carries a coupon interest of 10% and interest is payable on 31 Dec each year. Costs of issuing the bond, which included underwriting fees, totaled RM1,000,000. The costs were capitalized as a deferred charge and amortized on the straight line method. Show the entries to (a) record the issue of bond on 1 Jan 1999 (b) recognize the amortization of the bond issue cost and interest expense

Solution for Exercise 5.5

a)

Journal entry to record the issuance of the bond Dt Cash 39,000,000 Dt Deferred bond 1,000,000 Kt Bonds Payable 40,000,000

b)

c)

Journal entry to recognize amortization of deferred charge Dt Amortization expense 200,000 Kt Deferred bond 200,000 Journal entry to recognize interest expense Dt Interest expense 4,000,000 Kt Cash 4,000,000

ISSUE OF BONDS IN BETWEEN OF TWO INTEREST DATES

Adjustment for accrued interest should be done. Accrued interest is calculated for the period in between of the date of previous interest payment with date of bond is sold. Cash paid by buyer is the price of the bonds together with the accrued interest. Price of bonds is the present value of the bond at the date of selling/buying.

Exercise 5.6

Cumi Bhd purchased bond from Ciki Bhd. The following is the information on the bond.
June 30, 1999 June 30, 2004 Sept 1, 1999 Dec 31 and June 30

Date of bond Maturity date Date of selling the bond Date of interest payment

Stated interest rate

Face value of bond

9%
RM200,000

Prepare journal entries on 1 Sept and 31 Dec

Solution for Exercise 5.6

Issued at par Effective interest rate = 9% Price of bond Face value [PV4.5%, 10 200,000 = 0.64393 x 200,000] Interest [PVOA4.5%, 10 9,000 = 7.91272 x 9,000] Present Value (+) Increment of bonds value from 30/6 1/9 [200,000 x 9% x 2/12] Cash (-) Cash paid for interest from 30/6 1/9 [200,000 x 9% x 2/12] PRICE OF BOND AT 1/9/99

128,786 71,214 200,000 3,000 203,000

(3,000) 200,000

Solution for Exercise 5.6 (cont.) Journal entries

Sept 1 Dr Cash 203,0001 Cr Interest Payable 3,0002 Bonds Payable 200,000
1. 2.

Sept 1 Dr Investment Bonds 200,000 Interest Receivable 3,000 Cr Cash 203,000

200,000 + 3,000 (interest) 200,000 x 9% x 2/12 Dec. 31 Dr Cash 9,000 Cr Interest Revenue 6,000 Interest Receivable 3,000

Dec. 31 Dr Interest Payable 3,000 Interest Expense 6,0001 Cr Cash 9,000 1. 200,000 x 9% x 4/12

Solution for Exercise 5.6 (cont.)

Issued at discount Effective interest rate = 11% Price of bond Face value [PV5.5%, 10 200,000 = 0.58543 x 200,000] Interest [PVOA5.5%, 10 9,000 = 7.53763 x 9,000] Present Value (+) Increment of bonds value from 30/6 1/9 [184,925 x 11% x 2/12] Cash (-) Cash paid for interest from 30/6 1/9 [200,000 x 9% x 2/12] PRICE OF BOND AT 1/9/99

117,086 67,839 184,925 3,390 188,315

(3,000) 185,315

Solution for Exercise 5.6 (cont.) Journal entries

Sept 1 Sept 1 Dr Cash 188,3151 Dr Investment Bonds 185,315 Disc on Bond 14,6852 Interest Receivable 3,000 Cr Interest Payable 3,0003 Cr Cash 188,315 Bonds Payable 200,000 1. 185,315 + 3,000 (interest) 2. 200,000 185,315 3. 200,000 x 9% x 2/12

Solution for Exercise 5.6 (cont.)

Date Cash Paid Interest Amortisati on of Expense discount Discount not amortised Carrying amount of bond

30/6
31/12 30/6

9,000 9,000

10,171 10,235

1,171 1,235

15,075
13,905 12,669

184,925
186,096 187,331

Solution for Exercise 5.6 (cont.)

Dec. 31 Dec. 31 Dr Interest Expense 6,7811 Dr Investment in Bonds 781 Interest Payable 3,000 Cash 9,000 Cr Disc on Bonds 7812 Cr Interest Revenue 6,781 Cash 9,000 Interest Receivable 3,000 1. 10,171 x 4/6 2. 1,171 x 4/6, OR:
= 186,096 - 185,315 or = 1,171 (3,390-3,000)

RETIREMENT OF BONDS
Before the maturity date Examples of bonds retirement: 1. Refunding 2. Converted Bond 3. Callable Bond At the maturity date If bond is retired at the maturity date, no profit or loss is recorded Carrying Amount of Bond = Face Value of Bond Journal entry for payment made at the maturity date: Dr Bonds Payable XX Interest Payable XX Cr Cash XX Discounts on Bonds Payable XX

Refunding
Bond is retired by issuing new bond. At the retirement, all records on bonds and any related records to the old bond will be eliminated. Interest expense and amortisation of discount/premium needs to be recorded in advance until the retirement date.

Example

On January 1, 1995, Wira Company issued RM100,000, 10-year bond at par and with stated interest rate of 5% paid every 30/6 and 31/12. On January 1, 1999, the buyer agreed to receive bond of RM90,000, 20-year, with stated interest rate of 8% paid at the same dates. Market interest rate is 8%.

At the issuance of the bond: 1/1/95 Dr Cash 100,000 Cr Bonds Payable 100,000 At refunding Value of new issuance of bond = RM90,000 (at par) 1/1/99 Dr Bonds Payable 5% 100,000 Cr Bonds Payable 8% 90,000 Cr Gains from retirement 10,000

Converted Bonds

Bonds can be converted into shares Reasons for conversion: to increase the share capital or to make the bond marketable Entries for issuing of the bonds 2 methods: excess from sale as equity (separate between debts and equity) the excess is considered as debts (no separation between debts and equity) Entries for converting bonds to shares: 2 methods: 1. Book value method 2. Fair value method

Methods for Converted bonds

a) BOOK VALUE METHOD Record of share and premium at book value of bond at the conversion date No gain/loss is recorded If fair value of shares > book value of bond there is a decrease in retained earnings b) FAIR VALUE METHOD Shares and premium are recorded at fair value of the issued shares Gain/loss is recognized Gain/loss = Fair Value of the shares - Book Value of the bonds Gain/loss is considered as ordinary item in an Income Statement

Exercise 5.7: Converted Bonds

Tania Company issued at a premium of RM60 a Rm1,000 bond convertible into 10 shares of ordinary shares (par value RM10). At the time of conversion the unamortised premium is RM 50. The market value of the bond is RM1,200 and the shares is quoted on the market at RM120. Record the journal entries using: 1. Book value method 2. Fair value method

Book value method

DR Bond payable 1,000 DR Premium on Bond Payable 50 CR Ordinary shares CR Premium shares

100 950

Fair Value Method

DR Bond payable 1,000 DR Premium on Bond Payable 50 DR Loss on Redemption of Bond 150 CR Ordinary shares 100 CR Premium shares 1100

Callable Bonds

Normally the bond is repaid at the maturity date. CAN be repaid at any time if it is called up. Normally the bond is callable when the market interest decline refinance at lower rate At the callable date, the company should record all interest expense and amortise the discount/premium until that date. When the bond is callable, it is retired. Thus, all record of the bonds and any related to it will be eliminated.

Other Instrument for Long Term Liabilities

1.

Convertible Bonds (CULS)

Debt securities that are exchangeable into ordinary shares at the option of the holder and under specified terms and conditions

2.

Warrants (Transferable Subscription Rights)

Gives the holder right to subscribe specific number of shares at the pre-determine exercise price and within a specified period of time

Other Instrument for Long Term Liabilities (cont.)

3.

Irredeemable Convertible Loan Stocks (ICULS)

Quasi-debt pay annual coupon over their tenure but irredeemable in future, means there will be no repayment of principle at maturity Mandatory converted Faced value of ICULS will be converted into new ordinary shares based on stipulated conversion ratio

Exercise 5.9: ICULS

On 1 Jan 2002, Tom & Jerry Company issues RM1 million ICULS 2002/2006 value at RM1.00 per ICULS. The five-year ICULS paid 7.5% coupon per year. This ICULS can be converted into ordinary shares based on conversion ratio of RM5 ICULS for one new shares (RM1.00, par) Journal entries at issuance and conversion?

Solution for Exercise 5.9

At Issuance DR Cash CR ICULS
1,000,000 1,000,000

At Conversion (maturity date) RM1 million ICULS = # shares? New shares = 1,000,000 5 = 200,000 units shares DR ICULS 1,000,000 CR Ordinary shares CR Premium on shares

200,000 800,000